With The Yield Curve Threatening Again ‘Messy’ Will Be The Dominant Theme

For a while there it looked like the blow-off top of this expansion was somewhere in the future. Now it’s starting to look like 2017 was as good as it’s going to get – with serious implications for stocks, bonds and real estate.

At least that’s what interest rates now seem to imply. From today’s Wall Street Journal:

A bond market barometer that briefly suggested growth was perking up has reversed course.

The so-called yield curve, typically calculated by measuring the differential between short- and long-term Treasury yields, has been flattening in the last few weeks. Long-term yields have fallen in response to tempered expectations for growth and inflation, even as short-term rates extend their months-long rise.

The differential between the two-year yield and 10-year yield on Thursday shrank to 0.54 percentage point, the smallest since Jan. 26, coincidentally the day of the S&P 500′s last record high, Tradeweb data show. That was near its January low, which had been the lowest in a decade.

The yield curve flattened this week as long-term yields fell after a slew of lackluster economic data. Retail sales slipped 0.1% in February, their third straight monthly decline, data showed Wednesday. And data on consumer and business prices showed inflation pressures remain modest.

Investors watch the yield curve because it can signal that the economy is speeding up when it steepens. It can show the opposite when it flattens. And when short-term Treasurys yield more than their long-term counterparts, it signals that a recession is coming.

The yield curve also influences portions of the stock market — lifting banks and financial firms when it steepens and pushing up utilities when it flattens. On Wednesday as the curve flattened, the S&P 500 utilities sectors outperformed the benchmark, while the financial sector underperformed.

Rising yields this year had made the yield curve steeper throughout parts of the winter, but recent economic data has dampened those expectations. At the beginning of this month, the Federal Reserve Bank of Atlanta’s real-time GDP tracker projected the U.S. growing at a 3.5% annual pace in the first three months of the year, but by Wednesday, it had fallen to 1.9%.

Though some have recently questioned the curve’s forecasting power, many say it still offers a reliable signal. “Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession,” said Federal Reserve Bank of San Francisco economists, in a research note earlier this month.

Definitively an ominous trend, this, and one that’s consistent with a long-in-the-tooth expansion like today’s. But nothing in this hyper-complicated world is ever simple, so before assuming that a recession is neigh, be sure to note that US home pricesjumped 9% in February, import prices rose more than expected, and labor markets continue to tighten. And who knows what the nascent trade warwill evolve into.

The take-away? There are even more than the usual number of moving parts to consider this time around. Which means the party can end suddenly via some kind of discreet inflation/geopolitics/stock crash event or very slowly via an accumulation of Fed rate hikes, moderating growth, and rising trade barriers. Either way, “messy” is likely to be 2018’s dominant theme.

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